What LLC tax ‘fairness’?

Published: March 12, 2010

The one thing attorney Mark Fernald got right in his recent opinion piece on the so-called LLC tax (“Here’s the truth about the ‘LLC tax,’” Feb. 12-25 NHBR) is that it’s not a new tax, just a change to the existing interest and dividends tax. But what a change it is!The purpose of the original I&D tax was not, as Fernald claims, to tax the “wealthy” — it was to change the method of taxing investments, such as shares of stock or bank accounts, which formerly were taxed on their value, like real estate. In 1923, the Legislature substituted income from the investment as the taxable property instead of the property itself. This new, more convenient system taxed rich, poor and middle-class investment owners alike. Indeed, the new tax could not have taxed just the wealthy for it would clearly have violated the “rule of equality” that has governed New Hampshire tax policy for 150 years.With one exception, the new tax did not distinguish between types of taxpayers either. Individuals, fiduciaries, trusts, associations and partnerships that received interest and dividends were all subject to the tax. Corporations, however, were excluded in order to prevent double taxation: that is, taxing income coming into the corporation and taxing it again when paid out as a dividend to the shareholder. In 1993 the new LLCs were incorporated into this tax framework.For most of its existence, the I&D tax was narrowly focused on passive investment income. It was not intended in 1923 or thereafter to tax income earned from the performance of services, or other forms of investment income, such as capital gains or rents. Then last June the Legislature, relying on the advice of the commissioner of revenue administration, enacted a far-reaching amendment that removed all partnerships, associations and LLCs — regardless of whether or not their shares are freely transferable — from the list of taxable persons. This exclusion came with a significant “Catch-22,” though.The owners of partnerships and LLCs are now taxed on all distributions of income from their business. For example, if an LLC has capital gains, the gains, when distributed to the owner, are recharacterized as taxable “dividends.” As written, the law change is so broad that even income earned by an LLC owner from performing services as diverse as auto repair or beautician could be recharacterized as taxable dividends.At this point, the commissioner stepped in and (making law where the Legislature neglected to) proposed rules that allow a “reasonable compensation” deduction to the LLC owner to remedy the possibility that earned income would be taxed.“Reasonable compensation” is a concept unique to the business profits tax and is its most problematic feature. The concept is difficult to interpret and costly in terms of auditor hours to enforce. Many attempts have been made to legislatively “clarify” the provision, but most, including several bills introduced this session, only muddy the waters further. By incorporating this provision into the I&D tax, the commissioner has exponentially expanded the complexity of the law.Further, the burden of compliance on the owner is increased commensurately. Even if eventually some taxpayers find they owe no tax, the time taken from making a living, the anxiety of trying to comply with abstruse concepts, plus the cost to acquire expert accounting and legal help is likely to be a significant economic burden.Attorney Fernald alleges that the new tax law changes and the extensive new rules are necessary to correct “unfairness” in the tax. Paradoxically, these changes result in more unfairness, because neither the new law or rules change the way the I&D tax treats trusts, fiduciaries or individuals.Consider the example of two identical businesses, one organized as an LLC with a single member owner and the other an individual operating as a sole-proprietorship. Each business realizes capital gains from the sale of real estate during the tax year. Each owner/proprietor pockets the profit from the sale. The LLC owner’s profits, however, are taxed at 5 percent as a “dividend,” while the sole-proprietor pays nothing. Just possibly some of the LLC’s gain may escape the tax, if the commissioner allows the compensation deduction. The proprietor, on the other hand, entirely escapes DRA scrutiny. Where is “fairness” in this scenario?Val Berghaus of Deering is a former general counsel of the Department of Revenue Administration.

This article appears in the March 12 2010 issue of New Hampshire Business Review